ECONOMYNEXT – Sri Lanka’s main opposition Samagi Jana Balawegaya stands for reform of the central bank to ensure accountability and transparency as well as independence, its leader Sajith Premadasa said as the agency is in the throes a currency crises after a bout of money printing.

Since its creation in 1950 in the style of a Latin America central bank by a US money doctor, the agency has pushed up the cost of living, triggered currency depreciation and social unrest, creating severe difficulties for elected administrations and de-stabilized their economic programs.

Similar situation takes place in other Latin American nations despite severe fiscal corrections. Such central banks which sterilize the balance of payments drive countries into dollar sovereign default even with budget surplus, as shown in the case of Mexico in 1994.

Sri Lanka however is also hit by an expanding budget deficit now. Rising inflation from two years of money printing has forced the current administration give a ‘relief package’ further pressuring domestic credit and inflation if the handouts are financed by the central bank.

After the end of a 30-year civil war, amid rising monetary activism and discretionary or flexible policy Sri Lanka had hit currency crises in 2011/12, 2015/16, 2018 and a 2020/2021/2022 on is ongoing.

Rules vs Discretion

The SJB stands to “ensure that there is greater transparency, accountability, responsibility as far as the main monetary institution is concerned,” Premadasa told Colombo-based foreign correspondents.

“In our economic team we all agree that we have to put in place legislation to ensure that its independence and autonomy is guaranteed.”

Sri Lanka’s imports are now soaring, inflation is soaring, forex shortages are acute and money is being printed to sterilize interventions and keep rates far below inflation.

When the agency printed money and created forex shortages after 1950, people and businesses have been hit by trade controls, exchange controls and price controls leading to blackmarkets, corruption and loss of respect for rule of law.

Currency depreciation also triggered calls for subsidies. Depreciation and inflation reduces real salaries of public sector officials exposing them for corruption.

Singapore for example saw high levels of malnutrition and public sector corruption as the British returned afer World War II, due to wartime inflation triggered by Japanese ‘Banana money’, which its leaders later said led to a ‘corrosive effect on personal integrity.’

The British Military Administration (BMA) which took over and imposed price controls was dubbed the Black Market Administration. Under Keynesianism the UK also had price controls and rationing.

Singapore however maintained the British style currency board, and now appreciates its currency whenever the US prints money and creates global inflation. (Why Singapore chose a currency board over a central bank)

Razeen Sally, a classical economist, has said while a currency board may not solve all problems (a panacea) in the country, rules over discretion was the way to go.

“What was essentially a pretty strict, rule based regime to limit political and bureaucratic discretion – very roughly equivalent to a fixed and non adjustable peg – was transformed in 1950, thanks to the design the tutelage of John Exter, let’s not forget, under a UNP government with J R Jayawardene as Finance Minister, into discretionary, central banking,” he said in September 2019, just as the agency was buying bonds from past deficits, to end monthly BOP surpluses and start the current cycle of reserve depletion.

“And since then, we’ve had at least some periods where monetary policy with discretion over the rules has reinforced the mistakes of fiscal policy rather than leaning against it as it were.”

“I think that move away from the currency board to discretionary central banking was perhaps one of independent Ceylon’s early birth defects in the light of what’s happened subsequently.”

Related Breaking currency board was early birth defect of independent Sri Lanka: Sally

Others have gone further and called for an orthodox currency board or dollarization to strictly tie the hands of activist central bankers and allowing for free trade and non-inflationary growth.

The China Port City special economic zone has been ‘dollarized’ (mutliple currency area) protecting it from the Monetary Board and domestic money printing.

Flexible Policy

In the last ‘Yahapalana’ administration in which Premadasa was a minister, the central bank printed large volumes of money through multiple means to artificially control short and long-term interest rates and busted the currency from 131 to 182 to through two currency crises.

Inflation spiked and growth collapsed after each money printing bout and the administration became unpopular.

The central bank found new and innovative ways of injecting liquidity to control interest rates and de-stabilize the external sector during the last Yahapalana administration as growing public opposition to the naked purchase of Treasury bills, reduced its ability to cripple Treasuries auctions.

In 2015 large volumes of money was released by terminating term repo deals and then Treasury bills were bought, through term and overnight reverse repo auctions to suppress rates as budget deficits and private credit expanded in an exercise that began around the third quarter of 2014.

The external sector started to stabilize after then Governor Arjuna Mahendra suddenly ordered the head of domestic operations to halt money printing in March 2016 after the rupee fell to 145 from 131.

“On or about 03rd March 2016, Mr. Mahendran had telephoned Mr. Rodrigo (head of domestic operations) and instructed him, that the conduct of Reverse REPO Auctions should be immediately stopped, so as to stop the injection of liquidity into the market through Open Market Operations. “In this connection, Mr. Rodrigo said that the “Governor telephoned me in the morning, and said to immediately stop conducting of reverse REPO Auctions.”, according to report of of Presidential Commission into securities fraud.

The crisis stopped at 151 to the US dollar.

After stabilizing the external sector with non-contradictory policy 2017 and sell-downs of Treasury bills held by the agency (deflationary policy) the central bank again printed money to suppress rates and created another currency crisis in 2018.

In 2015 the fiscal authorities raised state salaries and gave subsidies, contributing to high domestic credit growth and interest rates which were suppressed by the central bank with printed money, blowing the pegged exchange rate and balance of payments apart.

Politically Difficult Fiscal Fixes

However in 2018 after Finance Minister Mangala Samaraweera and State Minister Eran Wickremaratne was appointed, central bank independence was publicly defended.

Politically difficult tax hikes which reduced the deficit and a price formula for fuel also removed any de facto fiscal dominance from state linked credit.

However money was again injected from around the end of the first quarter of 2018 and rates were cut in April – a month in which credit demand spikes due to state salary advances requiring higher rates- and printed money through multiple means to keep rates below the lowered policy ceiling by generating excess liquidity.

Money was also printed through a so-called ‘buffer strategy’ where maturing bonds from past deficits were not rolled over as paper harmlessly, but was repaid from bank overdrafts re-financed with central bank window money expanding reserve money.

The legality of the operation has not been questioned in court.

Money was also injected through overnight and term repo auctions. After the currency collaped and stabilized at a little over 160 the central bank again started printing money around July 2018 including through the creation money against Hambantota port dollar lease sale proceeds (rupee generating swaps) held as a Treasury reserve.

Predictably Sri Lanka missed a reserve target under an IMF program, the currency fell, inflation spiked and growth collapsed in a classic second ‘stop-go’ cycle for the second time. (Sri Lanka to miss IMF forex reserve target; seek waiver)

Foreign borrowings also spiked as foreign shortages made it difficult to repay maturing debt with current inflows, despite the politically difficult fiscal corrections made by the political establishment.

During the last administration money was also printed through outright purchases of bonds at various points along the yield curve jettisoning a ‘bills only policy’ put in place by prudent central bankers in the past.

The agency had also done an ‘operation twist’ style exercises (buying long term bonds with printed money and selling short term) to manipulate the gilt yield curve and generate instability by altering rupee reserves of individual banks after the end of a 30-year war, analysts have shown.

Financial Repression

In addition to expanding reserve money through liquidity injections the central bank also engaged in other naked acts of financial repression at broader money supply levels, including suppressing interest paid to small savers in banks as inflation spiked after the currency collapse.

Other tools such as ‘Stage III’ force sales of bonds at controlled rates were also bought into to buckle Treasuries auctions amid rising credit demand.

All the actions were done while operating a ‘flexible inflation targeting’ framework (a discretionary domestic anchor) with a ‘flexible exchange rate (a discretionary external anchor) which were in conflict with each other, naturally leading to currency trouble.

Under flexible exchange rate the rupee was depreciated to target a Real Effective Exchange Rate Index ( de facto inflationary external anchor) including in 2017, when deflationary policy was followed (no money was printed) and billions of dollars of foreign reserves were collected.

As money was printed and the BOP gave way trade restrictions were slapped and ammunition was given to import-substitution cronies and anti-free traders to ratchet up their rhetoric and exploit poor consumers.

The then administration’s free trade agenda was also discredited. Similar situations had encountered administrations in the past, that wanted to open trade, including a 1965 administration which brought the Import and Export Controls Act in 1969.

Monetary Activism

Unlike the current administration which pursued an active strategy of money printing on the style of Modern Monetary Theory (an extreme form of output gap targeting), it was not the case in the last administration after Samaraweera became Finance Minister.

In 2018 as large volumes of money was injected to generate excess liquidity and target call rates the middle of the corridor State Minister Harsha de Silva publicly requested the central bank to reduce money printing, even if policy rates themselves were not raised.

“As you now see, overnight call money rates have almost hit the ceiling at 8.5 percent,” de Silva told a public forum at the time. “If it is hitting the ceiling and you’re not injecting money at below 8.5 percent, then it’s alright and there’s no need currently to increase your policy rates.

“But at least let the overnight rates be within the higher margin of the policy rate. It’s prudent.
“Of course it’s going to have a negative impact on growth, but that is what we have to give to have some sort of stability on the exchange rate.”

Allowing rates to hit the ceiling creates a liquidity short, requiring only the minimum amount of money to be printed, unlike the large volumes of excess liquidity needed to maintain a rate below the ceiling under call money rate targeting.

At the beginning of 2021 the central bank was creating 200 billion rupees of excess liquidity to target call money rates below the ceiling even as reserves were being steadily lost compared to 60 billion rupees in the 2018 liquidity assault.

Corrupted Monetary Anchor

It is rare for ruling party politicians in Asia to plead with a central bank to tighten monetary policy, though in the US Congress, some senators have taken money printing Fed Chairmen who triggered bubbles to task.

However de Silva was ignored.

Politicians as legislators however have the legislative power to reduce the discretion of central bankers to print money and de-stabilize the external sector, by removing specific sections in the monetary law, under which authority is claimed for discretionary policy.

However most of the results of the liquidity operations, run contrary to Section 05 (a) of the monetary law, which requires the agency to maintain “economic and price stability”.

The legality of ‘flexible inflation targeting’ and ‘flexible exchange rate’ has not yet been questioned in court, though top economist W A Wijewardena had pointed out that creating excess demand to target output gaps is not the intention of the monetary law.

Related Sri Lanka has a corrupted inflation targeting, output gap targeting not in line with monetary law: Wijewardena

The central bank in 2018 sought to legalize highly discretionary policy including the inconsistent ‘flexible exchange rate’ through a new monetary law and also indemnify its officers. The law had not been passed.

There have been growing calls to abolish the central bank in favour of an East Asia style currency board to enable free trade and eliminate currency trouble or at least bring laws to limit the discretion given to trigger happy central banker to control rates.

The earlier currency board which was abolished in 1950, had kept the Sri Lanka and the rupee stable during two World Wars and Great Depression (other than when the gold silver parity changed), while the Latin American style peg creates external trouble each time the Fed tightens policy as well as in the run-up, when commodity prices zoom up.

Tying the hands of activist central bankers also provides a hard budget constraint, in addition to bringing monetary stability, low inflation and social harmony and eliminates strikes as they did in Germany and Japan even as Western output targeting countries were mired in social unrest before 1980.

Analysts say unless curbing central bank activism is made a cornerstone of reform as was done by Singapore, China (separation of PBoC re-finance units into commercial banks in 1978 and more radical reform after 1987 debacle), Vietnam (separation of re-finance into commercial banks economic implosion after 1986 opening and progressive reform of peg) no economic program or free trade, will survive. (Colombo/Feb07/2022)